Limited Attention and Dynamically Distorted Beliefs

We study the effects of limited attention on belief formation in a dynamic environment. We propose a simple theoretical model of inattentive learning and derive closed-form expressions for the limiting distortion of the true underlying distribution. When attention is drawn towards extreme observations, the limiting probability distortion takes the form of an S-shape. These belief distortions yield behavior that is similar to that implied by the preference-based distortions of prospect theory. We thus find that part of the empirical success of prospect theory might be due to abstracting away the impact of limited attention on learning. We show that our model of inattentive learning explains several aspects of investors behavior, for instance, a preference for skewed assets; overextrapolation of past returns; stock market momentum; and the simultaneous demand for lotteries and insurance. When attention has cognitive costs, limited attention thus provides a rational unification of several biases in investor behavior